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Are Small-Cap Indexers Hurting the Performance of Active Funds?

An investigation into a common complaint of active managers.

Some active small-cap managers bemoan the industry’s secular shift toward passive products as a direct cause of their performance struggles. They often claim that heavy flows into indexlike or smart-beta products can distort the prices of small-cap companies due to their illiquidity; the impact of the flows to passive products theoretically outweighs the market movements resulting from the price discovery of other transactions. In turn, less-attractive index constituents rally undeservedly, the active portfolios’ stocks struggle to outperform the index amidst the overwhelming force of the passive flows, and managers don’t get rewarded for discovering sound fundamental companies that may be less prominent in or excluded from the benchmark. This phenomenon contributes to the fund underperforming its benchmark net-of-fees.

While this assertion flows logically, research has not found a relation between flows to passive small-cap products and active small-cap fund performance, and a look into small-cap managers’ performance compared with small-cap asset flows suggests no causal relationship. If this theory were correct, one would expect to see that periods of high passive inflows would correlate with weaker active performance over time.

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